Bharat Shah, Executive Director, ASK Group, dwells on value investing and how he formed his investment tenets
18-Sep-2014
You are known to be a value investor. How do you judge value in a stock?
300 years of recorded global history of investing throws up some essentially very simple but very valuable ideas. These can be profitably woven in and made integral to one's investment philosophy and approach to stock selection. Philosophically, three ideas are dear to me. One, certainty of growth of earnings (even if somewhat modest) is far more valuable than a dazzling growth but which is one time, uncertain or indeterminate. Two, quality of growth (as represented by capital efficiency) adds far more to long-term value creation than just the earnings growth. Three, it is important to buy only quality at as good a margin of safety as one can get, rather than buying inferiority but justifying that with arithmetical "cheapness", which more often than not is a "honey trap".
As far as stock selection criteria are concerned, which create long-term value, there are five simple ideas, which I regard as material. One, Size of Opportunity is a mother idea. It is less about how big a business was or is. It is virtually all about how big it can get from where it is. It dwells almost entirely in future rather than in the past or present. It is more about the size of a pond rather than the size of a fish. Pond has to be large so that there is headroom for a capable fish to grow.
Two, Management Quality is far more tangible than is believed to be. In the buoyant phase of markets, this truth is conveniently ignored but at one's investment peril. This can hardly be over-emphasized. Capital allocation and capital distribution skills are the hallmarks of a good management. Integrity, vision and execution are the defining attributes of a quality management. It is only when a large size of opportunity meets with quality management, that the outcome is gratifying.
Three, the union of the above two results in the Earnings Growth. This is key because the absence of growth or its materiality reduces equities to bonds. The growth doesn't necessarily have to be dazzling. What's more important for the growth is to be long-term, relatively predictable and consistent. Such growth creates compounding machines.
Four, while growth is essential, it is not enough by itself. It needs to be Quality Growth for it to create value. Quality comes from the ability of the underlying business to create rising economic value. That can happen only when business generates not only superior but also durable, predictable and consistent ROCE. Quality of business is at a heart of good stock picking for outstanding long-term value creation. Again, it is only when a reasonable growth cohabits with high quality of growth, that great economic value is created.
Five, an investor in a (such) business can create investment returns only if the underlying business can create economic value. Ultimately, investing is nothing if not business like. It is a myth to believe that one can earn investment returns even if the underlying business has inferior economic value creation; or, that a business creates outstanding economic value but somehow does not get reflected in investment returns. Neither can happen. Certainly, not over a long enough period of time. An investor can generate investment returns, even superior to the underlying economic returns if he can buy such a business at a Margin of Safety (or, Price-Value Gap) to its intrinsic worth. In essence, the science and art of investing lies in the above, rather, simple ideas. However, investing is simple but not easy.
With your experience, what advice would you give to a young investor who is just getting interested in equities? How does one start?
No advice, but some suggestions. Investing is a game of patience and one for the long-term. Both are not necessarily the same but both are called for in ample measure in investing journey. Again, investing is simple but not easy. Simple, because the investing principles are pretty straight forward and there is nothing really overly profound about them. Not easy, because the toughest part is to follow the principles with discipline and wisdom. Investing ability is built and honed over a period of time, through an eclectic mix of insights, experience, passion, intensity and hard work.
Essentially speaking, successful long-term investing calls for two vital technical capabilities or craft and two personality traits. While craft can be honed and refined by observing and absorbing, character traits have to come from within and be developed. The two essential skills are: ability to comprehend and grasp the true character and the innards of diverse businesses as well as the ability to value them. Till these abilities are developed, one cannot become a good investor. The two vital character traits are: discipline (or temperament) and wisdom. Discipline lies in investing only into quality businesses and the temperament of not getting carried away by the fads of the markets and buying such quality businesses only at a meaningful margin of safety.
Having bought a good business, an investor needs the wisdom to stay the course and not get swayed by the short-term machinations of the market, or to part with the journey prematurely. Markets don't know that you have bought the stock. They don't have to reward you from the next day.
Relatively speaking, investing is more about wisdom and somewhat less about intellect. You don't need to have an extraordinary intellect or need to be a genius to succeed in investing. High intellect with low wisdom is a recipe for destruction. High wisdom with reasonable intellect is a perfectly rewarding combination. I strongly believe that wealth or money is not something to flirt with even if it is your money. It is the duty, if not dharma, of everyone to do well for one's own money. When you do that well at a micro-level for yourself, you help in contributing to do so at the society level. And if one can't bring to bear all of the above traits while investing, then one is better off finding out whom he can entrust that responsibility. Investing is not necessarily a DIY scheme.
Valuations across the markets have turned very rich; do you see pockets of value to invest for the long term?
I don't agree. While markets indeed have gone up, it is not as if some dramatic or cataclysmic rise has occurred. At a broad level, market valuations are just about fair or even a tad below. And at a micro level, there are plenty of quality opportunities available at reasonably attractive valuations. Also, there is an overbearing tendency to judge valuation from the prism of a rather simplistic and inadequate yardstick such as price earning multiple. Growth of profits over long time and even more importantly, quality of growth, have far more impact on the valuations than what a shortterm number such as price earning multiple can ever capture. Judged by these yardsticks, I remain comfortable with the valuations.
An unfortunate reality is that over past three decades, the equity culture in this country has progressively declined to become rather shallow and narrow such that, the equity thinking has become unduly obsessed with the short-term, at the expense of valuable long-term.
Hence, even a rather small rise, as what the markets have recently posted, seems to occupy and weigh upon the minds of most people as if the markets have gone up way too high. I want to reemphasize that we are just at the beginning phase of one of the most significant and valuable ascent of Indian equity markets.
Trying to judge such a phase so early, and again and again, may be popular but may not be profitable. In ultimate analysis, stock prices are slaves of earnings and if earnings are real, qualitatively sound and grow for a material period of time, then such growth is bound to reflect in the stock prices. Macroeconomic issues, beyond a point, make for only nice coffee table discussions but are hardly representative of profitable investment approach.
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